May 23 (Bloomberg) -- China’s interbank borrowing costs are
set for the longest slide in almost two years as policy makers
curb activities of higher-risk finance companies and channel
cash toward larger lenders.

The three-month Shanghai interbank offered rate fell 43
basis points in May to 5.07 percent, on track for a fourth month
of declines. The cost of locking in the rate for one year in the
swap market is even lower at 4.75 percent today. Shibor has
dropped from as high as 5.8 percent in June 2013, when the
People’s Bank of China choked the supply of cash to discourage
trust companies and issuers of wealth-management products from
using money borrowed from the market to finance risky loans.

The PBOC is easing monetary policy as growth in the world’s
second-largest economy cools to the slowest pace since 1990,
property prices fall and investment fades. It also needs to
ensure plentiful demand as China’s banks embark on sales of
preferred shares to allow them to absorb potential defaults,
while regional governments expand a municipal bond-market trial.

“Growth is the highest priority,” said Chen Qi, a
strategist in Shanghai at UBS Securities Co. “Investors are
betting on lower money-market rates. Policy makers are trying to
curb off-balance sheet lending and encourage development in the
bond market to become a substitute for corporate financing.”
She forecasts the three-month Shibor will decline to 4.5 percent
in the third quarter.

Funds Return

China is taking more measures to protect a 7.5 percent
annual growth target, after the economy expanded at a 7.4
percent in the first quarter. The 21st Century Business Herald
reported yesterday that the PBOC provided a 100 billion yuan
($16 billion) loan to China Development Bank for shantytown
development, while the State Council said on May 21 it will
double the amount of venture capital it makes available to
emerging industries.

“The central bank has come quite a long way from last
summer’s tightening bias, and with weaker economic activities in
mind, a repeat of June 2013 is looking very unlikely,” Qu
Hongbin, chief China economist at HSBC Holdings Plc in Hong
Kong, wrote in a report yesterday. “Funds are coming back to
the interbank market as a result of increasing regulatory
scrutiny on off-balance sheet lending activities.”

The Chinese Academy of Social Sciences, a state-run
research institute, this month described the interbank market as
a “critical link” that could exacerbate systemic risks in
times of a shortage of cash. Regulators have told lenders to
limit interbank borrowing to less than a third of liabilities,
while lending to another financial firm shouldn’t exceed 50
percent of Tier 1 capital, the PBOC said last week.

Cash Crunch

The risks associated with interbank lending were
underscored last year when the June cash crunch forced two
branches of China Everbright Bank Co. to delay repaying 6.5
billion yuan of short-term interbank loans after they failed to
receive proceeds from counterparties.

Finance companies in China circumvented restrictions on
lending to property developers and local government financing
vehicles by creating a web of shadow financing, estimated by
JPMorgan Chase & Co. at 46.7 trillion yuan. That often involved
interbank lending.

The PBOC’s open-market operations injected a net 120
billion yuan into the financial system this week, the most in
almost four months. Shibor may bounce back ahead of quarter-end
cash requirements next month as the PBOC may keep monetary
policy neutral unless growth “surprises to the downside,” said
Sameer Goel, Singapore-based head of Asia macro strategy at
Deutsche Bank AG.

Seasonal Spikes

“They will want to manage liquidity very prudently at this
point of time,” said Goel. “Shibor has already normalized.
It’s corrected very significantly. There will always be the
seasonal spikes in the middle of the fiscal year.”

The economy is forecast to expand 7.3 percent this year,
the slowest pace since 1990, according to the median estimate in
a Bloomberg survey. New home prices rose in April in the fewest
cities in a year and a manufacturing gauge stayed below 50, the
dividing line between expansion and contraction, for a fifth
month in May, data this week showed.

PBOC Governor Zhou Xiaochuan called for “vigilance” to
monitor whether growth slows further even as he said the nation
can achieve an expansion rate of 7.5 percent, which would match
the government’s target for the year. He spoke in an interview
in Kigali, Rwanda.

The slowdown has hurt the ability of borrowers to repay
debt and driven up bad loans. Nonperforming loans at Chinese
lenders increased for the 10th quarter to 646.1 billion yuan in
March, the highest since 2008, official data show.

Preferred Stocks

The China Securities Regulatory Commission in March allowed
banks to issue preferred stocks. Bank of China Ltd., the
nation’s fourth-largest lender by market value, is seeking as
much as 100 billion yuan by selling the securities, which count
as equity-like capital and allow banks to expand their
businesses.

A preferred stock sale “provides another channel for banks
to raise capital,” said Ken Peng, an investment strategist at
Citigroup Inc.’s private bank in Hong Kong. “There’s been a
continuous crackdown on shadow banking. If corporates have more
trouble finding credit, banks will be able to provide more
through the sales.”

Shibor may fall to around 4 percent as there is ample
supply of yuan in the financial system after the PBOC’s steps to
spur two-way currency swings, according to Wee-Khoon Chong, head
of Asian rates strategy at Nomura Holdings Plc.

Yuan, Bonds

The yuan has slipped 3 percent this year, the worst
performance in Asia, and was trading at 6.2372 per dollar as of
12:03 p.m. in Shanghai today. The 10-year government bond yield
has declined 38 basis points this year to 4.18 percent
yesterday.

Chong expects the PBOC to cut banks’ reserve requirement
ratio by 50 basis points before the end of June and deliver
another reduction in the third quarter. The amount of cash
China’s biggest banks must set aside as reserves has remained at
20 percent since May 2012.

“There is a chance for Shibor to fall back to June 2013’s
pre-tightening levels,” Chong said in Singapore. “Shibor is
falling due to active open-market operations, partly
unsterilized intervention and anticipated further easing.”